The price of living in the fantasy world of free-trade economics continues to rise for America.

Failure to recognise the pitfalls will probably mean a continuing struggle to emerge from recession, as much US domestic demand leaks abroad due to the trade deficit, rather than being recycled at home. And America will continue to lose key industries: not just the primitive ones a developed nation should shed, but the high-tech jobs of the future.

Any serious discussion of free trade must confront David Ricardo's celebrated 1817 theory of comparative advantage, whose tale of English cloth and Portuguese wine is familiar to generations of economics students. According to a myth accepted by both laypeople and far too many professional economists, this theory proves that free trade is best, always and everywhere, regardless of whether a nation's trading partners reciprocate.

Unfortunately for free traders, it is riddled with holes, some of which even Ricardo acknowledged. If they held true, the hypothesis would hold water. But because they often don't, it is largely inapplicable in the real world. Here's why:

* The first dubious assumption is that trade is sustainable. But when a nation imports so much that it runs a trade deficit, this means it is either selling assets to foreign nations or going into debt to them. These processes, while elastic, aren't infinitely so. This is precisely the situation the US is in today: Not only does it risk an eventual crash, but in the meantime, every dollar of assets it sells and every dollar of debt it assumes reduces the nation's net worth.

* The second dubious assumption is that the productive assets used to generate goods and services can easily be shifted from declining to rising industries. But laid-off auto workers and abandoned automobile plants don't generally transition easily to making helicopters. Assistance payments can blunt the pain, but these costs must be counted against the purported benefits of free trade, and they make free trade an enlarger of big government.

* The third dubious assumption is that free trade doesn't worsen income inequality. But, in reality, it squeezes the wages of ordinary Americans because it expands the world's effective supply of labour, which can move from rice paddy to factory overnight, faster than its supply of capital, which takes decades to accumulate at prevailing savings rates. As a result, free trade strengthens the bargaining position of capital relative to labour. And there is no guarantee that ordinary people's gains from cheaper imports will outweigh their losses from lowered wages.

* The fourth dubious assumption is that capital isn't internationally mobile. If it can't move between nations, then free trade will (if the other assumptions hold true) steer it to the most-productive use in our own economy. But if capital can move between nations, then free trade may reveal that it can be used better somewhere else.

* The fifth dubious assumption is that free trade won't turn benign trading partners into dangerous trading rivals. But free trade often does do this. This is especially likely when trading partners practice mercantilism - deliberately gaming the world trading system.

* The sixth dubious assumption is that short-term efficiency leads to long-term growth. But such growth has more to do with creative destruction, innovation and capital accumulation than it does with short-term efficiency. All developed nations industrialised by means of protectionist policies that were inefficient in the short run.

What is the implication of all these loopholes in Ricardo's theory? That trade is good for America, but free trade, which is not the same thing at all, is a very dicey proposition.

There is an appropriate policy response. For starters, the US should apply compensatory tariffs against imports subsidised by currency manipulation, an idea that originated with the US Business and Industry Council and was recently passed by the House of Representatives. Also essential is a border tax to counter foreign export rebates implemented by means of foreign value-added taxes.

The US also needs tariffs on foreign goods and services that compete with existing and startup domestic producers, if only as bargaining chips to force other nations to play fair.

In 1971, US President Richard Nixon set unilateral tariffs against Japan, Germany and other countries that refused to let their currencies strengthen. Far from setting off a trade war, this persuaded these nations to help rebalance the world economy co-operatively. There is every reason to expect the same outcome today.

The longer we do nothing, on the assumption that the world trading system will rebalance itself, the more likely that it will break down in unpredictable and counterproductive ways.




- BLOOMBERG